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Financial Crisis Essay

3376 words - 14 pages

Financial Crisis

In recent decades, financial crises have stopped the momentum of economic development of many countries around the world. In some cases, they have destroyed almost completely different financial systems. The term financial crisis is applied broadly to a variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign ...view middle of the document...

However it still remains a challenge to understand and identify the deeper causes.
Financial crises are often preceded by asset and credit booms that eventually turn into busts. Many theories that describe the sources of financial crises have recognized the importance of asset and credit booms. However, explaining why asset price bubbles or credit booms are allowed to continue to a point where it is no longer sustainable has been challenging. We will now take a closer look on asset and credit booms and their impacts.
Asset bubbles are sharp increases in asset prices and often lead to crashes. A bubble, an extreme form of such deviation, can be defined as “the part of a grossly upward asset price movement that is unexplainable based on fundamentals.” A speculative bubble exists in the event of large, sustained overpricing of some class of assets. One factor that frequently contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future. If there is a bubble, there is also a risk of a crash in asset prices: market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall. However, it is difficult to predict whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles reliably. Some economists insist that bubbles never or almost never occur. Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and other asset prices include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese property bubble of the 1980s, the crash of the dot-com bubble in 2000–2001, and the now-deflating United States housing bubble. The 2000s sparked a real estate bubble where housing prices were increasing significantly as an asset good
Credit booms can be triggered by a wide range of factors, including shocks and structural changes in markets. Shocks may include changes in productivity, economic policies and capital flows. Rapid movements in asset and credit markets during financial crises are quite different from those normally observed. Asset and credit boom and busts differs from the movements observed over the course of a normal business cycle. An asset or credit boom usually takes place over shorter time periods and result in faster increases in the financial variables. The slope of a typical boom is two to three times larger than a regular episode, while a bust is much longer, deeper and results in a more violent downturn. Asset price busts can affect bank lending and other financial institutions’ investment decisions and in turn the real economy through two channels. First, when borrowing/lending is collateralized and the market price of collateral falls, the ability of the firm to rely on assets as collateral to retain loans or extend new credit becomes impaired. This in...

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